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Tuesday, September 13th, 2016

An illustrative inventory of Brexit issues for businesses
posted by Andrew Lilico

At present, quite a number of firms, across a range of sectors, are seeking our advice to help them think through how Brexit might affect them, and what sorts of risks and opportunities it presents. In this blog I will rehearse some of the kinds of issues we help firms think through.

A first set of issues concerns how Brexit might, in substantive terms, affect demand for your firm’s products. It’s easy to become so bogged down in the fascinating policy and internal change management issues that one misses more basic demand points. At the more prosaic level, Brexit might affect GDP, both in the shorter- and longer-terms. We help clients think through how demand for their products is related to GDP and how it changes in response to short-term fluctuations or longer-term trend shifts.

The period around Brexit and the longer-term may involve fluctuations in the value of Sterling relative to other currencies. Which movements are most plausible in the shorter- and longer-terms, and how might this affect your business?

How might Brexit affect the rest of Europe? Could it lead to extra EU members leaving the EU or joining the euro? How might your firm react? For example, might that mean you should expect less volatility for euro to zloty exchange rates? Could that affect your hedging operations or the prices you charge to Polish clients? Could it create investment opportunities, speculating on exchange rate movements?

UK policymakers are likely to respond to the macroeconomic movements associated with Brexit in the number of ways. The Bank of England already cut interest rates. How might the future path be affected? How might fiscal policy respond? How would your business be affected by that? Does it mean extra business taxes potentially affecting you? Might it mean extra spending on things you supply (e.g. procurement advisory services for government departments) or on things that could affect your sector (e.g. extra housing construction)?

Next, the process of Brexit might create sales opportunities. That could be particularly relevant if your business provides advisory services in areas such as regulation, recruitment, business strategy or change management. Brexit itself might affect demand for your products if your products have a patriotic, or Britishness or European-ness, historical, current-affairs-related or landscapes-related angle. For example, if you sell films, consumers might want movies with topics that help them think through or navigate the implications of Brexit for their lives, much as there were many movies made in the late 1980s about the opening up of Russia or the fall of the Berlin Wall in the 1990s.

Brexit might lead to new trade deals with the rest of the world. Which ones might happen and which won’t? Which deals create the best opportunities for your businesses to sell products abroad or to import useful inputs? How might trade with the rest of the world evolve in the future and how might that affect your business?

Could restrictions on free movement of persons affect your staffing or affect demand for your products? What restrictions are plausible? Might there be special visa exemptions for certain kinds of staff in your sector? Could you benefit if there were freer migration between the UK and non-EU countries? What will happen to the salaries you need to pay your staff?

How might changes to regulation affect your production or demand with respect to the EU? For example, will the Working Time Directive go? Could that affect your business if, for example, you do a lot of night-time production? How about with the non-EU? For example, if the UK has a closer relationship with the US and Canada, might that affect your firm’s ideal working hours? What categories of regulation that matter to you are more likely to be affected — e.g. Product regulation? Consumer protection? Environmental? Health and safety?

How might changes to intellectual property affect you? Presumably the UK will exit the EU patent exhaustion area, with great significance for pharmaceuticals. But will the UK be in the Unitary Patent? Will it remain in the European Patent Organisation? What will happen to design rights? Will there be a difference between the treatment of OHIM-registered design rights and those registered in the UK? What about copyright? What about digital property rights?

How might the structure of the UK economy change in response to Brexit? For example, might there be more manufacturing relative to services, because less free movement of labour tends to lead to greater capital intensity in GDP? More business services relative to financial services? Could the English West coast and Wales, facing the Atlantic, gain relative to the Europe-facing South-East? How could this affect your business? (e.g. Could it change real estate prices for you? Could it change the seasonality of demand?)

What new opportunities might be created for you by changes to competition or by the mistakes of your competitors? Could competition law change? What about mergers? Will it be harder for your firm to take over EU competitors? Will it be easier or harder for US rivals to buy you out?

How might taxes or tax reliefs be affected? Could there be tax reliefs for your sector that the UK government has up to now been prevented from providing because of state aid rules? Might Brexit change that? Does Brexit mean there might be more or less restrictive rules on tax avoidance or the tax treatment of debt? Could that affect the optimal way for your business to fund takeovers?

This is by no means a comprehensive list of the potential issues Brexit can create for businesses. And as well as there being additional issues in some sectors, some of the issues above may be irrelevant for you and would not be considered. But it is an illustrative inventory, showing some of the kinds of issues we have been advising clients upon.

01:21 PM | Permalink

Wednesday, November 18th, 2015

Active Asset Management risks mis-selling itself, when it does not need to
posted by Andrew Lilico

The asset management is about to be the subject of a competition probe by the Financial Conduct Authority.
The FCA is seeking to understand whether competition is working effectively to enable both institutional and retail investors to get value for money when purchasing asset management services.  More specifically, the FCA says it is interested in:
how asset managers compete to deliver value;
whether asset managers are willing and able to control costs and quality along the value chain; and
how investment consultants affect competition for institutional asset management.
These topics are important in their own right.  But at this it is less clear to what extent the FCA will probe the really big issue regarding asset management, arguably nothing less than a ticking time-bomb in the financial sector waiting to be either defused or detonated.  Across much of that sector there are funds offering “active management” of assets – they pick when to trade in and out and they pick particular sectors and investment strategies.  According to the FCA, about 78 per cent of funds’ assets are managed this way. The alternative to this is what is called “passive management”, whereby  funds track the FTSE, offer some combination of the stock market and a low-risk asset such as government bonds, or perhaps track some other slightly higher-risk index. In the industry jargon, investors in passively managed funds are said to “buy beta” – i.e. buying a desired level of involvement in the market average risk-return tradeoff - whilst those in actively managed funds are also buying “alpha” – i.e. outperformance of the market average return for any given level of risk.
Actively managed funds cost investors more for the management fees.  There is a standard result in the academic literature that says that, on average, although actively managed funds can outperform the market (they can generate “positive alpha”) the cost, in terms of management fees, of getting that higher return is greater than the return.  In other words, on average investors lose out by investing in actively managed funds. Some folk can get lucky by investing in an actively managed fund early in a fund manager’s career, before his or her reputation is established and the fees go up.  And of course in any one year actively managed funds might get lucky.  But the average is negative.
Why is this a ticking time bomb?  Because although they are familiar with this academic result (which has been around for some 25 years now), much of the funds sector refuses to accept it and consistently markets their actively managed funds on the basis that they can outperform passively managed funds.  So in, say, ten years someone retiring with an actively managed fund could say: “If I’d invested in a passively managed fund, I’d have a £3,000 per month higher pension.  And you knew that that would be likely to be so, because all the research told you that decades ago.  But you told me I would do better by investing in your actively managed fund.  That’s mis-selling, and I want you to make up the difference.”  Whether such appeals for compensation would or should be successful is of course a matter that could be disputed.  But it is a risk that at present the funds industry does not appear to recognise.
And that seems to be a mistake.  Because although the empirical result that active management costing more than the returns outperformance is often presented as either an illustration of markets functioning poorly or of how investors are not perfectly rational, increasing average returns should not be what one would expect active management to do in an efficient market.  Active management should be expected to change the profile of returns  - e.g. by reducing how much funds fall in a modest crash (really big crashes will tend to overwhelm everyone).  By doing things like this, active managers change the shape of returns – in the jargon that’s called the “skewness” – so there is less downside, relative to the upside.  Now in standard finance theory, it is commonly assumed, for simplicity and tractability of models, that investors care only about the mean and variance of returns but not the skewness, so changing skewness wouldn’t be worth anything.  But in standard microeconomic theory (for technically-minded readers, I’m referring to Arrow-Pratt risk aversion), investors should prefer a profile of returns with less downside, even if the average return is therefore slightly lower.  That means that in an efficient market, we should expect passively managed funds (with a market average skewness and downside risk) to have a higher expected return than actively managed funds (where downside risk is reduced).  To put the point more plainly, active management costing more than the returns outperformance it produces should not be a surprise and is not, in itself, an indicator either of bounded rationality or market failure. It is what one should expect if markets are functioning efficiently.
Of course, just because one should expect post-fees returns on actively managed funds to be less than on passively managed funds by some degree, that does not mean that just any degree of wedge between these two returns is efficient.  It could still be that the wedge in practice is higher than the wedge justified by skewness effects – so there could still be competition or market failure or bounded rationality issues to consider.
But even if there are not, there’s still a potential problem for the active management sector.  There should be nothing wrong with active management, per se.  What it achieves is to change the profile of returns.  But active managers need to be careful about how they sell themselves to investors.  At the moment, some may be running the risk of deceiving investors by claiming what they offer is higher average returns, when in fact what they offer is (on average) lower expected returns (after fees) but less downside risk.  That’s worth something. But you need to sell it right.
11:56 AM | Permalink

Friday, October 30th, 2015

Return on infrastructure assets vs. equity
posted by Europe Economics

At the UK governing Conservative Party’s annual conference on October 5th, Chancellor George Osborne announced that 89 of the UK’s local government pension schemes (LGPS) would be consolidated into six new “British wealth funds”.

At present only around 0.5 per cent of £180bn in LGPS assets are in infrastructure, or around £2bn. The government believes that this is partly because LGPS are too small to invest properly in infrastructure.  It notes that in countries with larger pooled public pension schemes, typical infrastructure investment is around 8 per cent — or around £14½bn, some £12½bn more than at present.

The following table shows recent determinations of the allowed return on capital for infrastructure assets by European regulators.  If the newly created British wealth funds were to move their capital into infrastructure, they will need to move them out of some existing investments. It is likely that they would need to sell some of their current equity to invest in infrastructure. If they want to keep the same overall portfolio return they would need to move some other funds into riskier equity since allowed returns on capital are lower than returns on equity, as illustrated indicatively in the table below. 

Table 1: Recent determination of the cost of capital for infrastructure

Source: regulators’ websites.
Note: return on capital showed in the tables are set on the basis of different assumptions (e.g. pre/post-tax) and should thus not be compared across countries. In jurisdictions where the return on capital is set on a pre-tax basis, the overall pre-tax weighted cost of capital may be smaller than the post-tax return on equity showed in the table. 

03:21 PM | Permalink

Thursday, October 1st, 2015

Re-repricing of risk for commodity dependent sectors
posted by Europe Economics

Figure 1: Rolling Asset Betas (2-years of daily data)

EE calculations based on Bloomberg data.

In the figure above we can notice that, over the last month, the asset betas of the materials and energy sectors have experienced a sharp increase, whilst the beta of the industrial has decreased.  Such changes can be rationalised as indicating a re-pricing of risk for commodity driven sectors (i.e. sectors that benefit from rising commodity prices) and industrial sectors (i.e. sectors that benefit from falling commodity prices).  More specifically, markets now perceive the former as riskier than the latter (whilst these sectors were perceived as equally risky in August).

Such re-pricing of risk might be due to the poor performance of commodities in September, after a rally recorded in the second half of August.

02:07 PM | Permalink

Friday, August 28th, 2015

Trends in perceived relative risks across UK equity sectors remains intact
posted by Vasileios Douzenis

Figure 1:  Rolling Asset Betas (2-years of daily data)

EE calculations based on Bloomberg data.

The “beta” of an asset tells us how the riskiness of that asset changes relative to the sum of all assets in the economy. Therefore, for a given equity sector, an increase in beta is interpreted as an increase in its risk relative to the equity market as whole. As noted in our previous newsletters, the general trend since 2014 has been a steady increase of the beta of relatively safe assets (e.g. utilities), and a decrease of betas of sectors perceived to be riskier (e.g. financials). In particular, the financials sector appears to be diverging from the other main equities sectors in moving to lower risk relative to the pack. We have interpreted this as a sign of potential normalisation of financial markets and a move away from “flight to safety” effects.
Since June 2015 financial markets have been subjects to at least two relevant events. The deterioration and subsequent resolution — at least temporarily — of the Greek crisis and, more recently, the sharp sell-off in equity markets across the globe amid fears of a slowdown in Chinese growth. It is of interest to notice that, despite these developments, the overall trend trajectory and momentum of UK equity beta have remained perfectly intact. 
10:47 AM | Permalink